Economists and financial reporters usually speak of inflation as if it’s an economic condition … something that may go up or down due to demographic or technological change.  It may rise due to a tight job market or if economic growth “overheats”.  As a wit once said though, inflation is always and everywhere a monetary phenomenon.  I’m going to take that a step further with a couple of illustrations that will help us get our arms around this and make it tangible and concrete.  For the purposes of this post, we define inflation as an increase in the general price level and will discuss expansion and contraction of credit later.

Suppose you say to me prices are rising so we therefore must be in an inflationary environment.  This seems obvious and indisputable.  Yet I must object.  Your observation is not one of objective reality and is not absolute.  It is dependent on your choice of unit of account.  It does not exist as an independent property of an economy, but is rather an observer created artifact of that choice.  

There are a multitude of choices available.  Here in the US, we habitually choose the US dollar.  In theory, anyone else making that same choice will observe the same state of inflation.  It should be clear though that other, less parochial choices are just as logically valid.  Someone shopping using the Japanese yen would experience a different change in the price level from year to year.  But wait, you interject with a satisfied gleam in your eye; the state of inflation in the Japanese economy doesn’t have to be the same as in the US economy.  

Certain as you may be that the debate is over, I must maintain my objection.  There is nothing stopping a holder of Japanese yen from coming to the United States and purchasing goods here, even if it means first converting his yen into dollars at the prevailing rate of exchange.  Either way, he will still find that the change in the prices paid in yen terms differs from that paid in dollar terms.  If inflation was a genuine property of the economy itself, as opposed to a property of the currency, that wouldn’t be the case.  

In contrast, the rate of unemployment or the number of homes sold will be the same no matter which currency you’re using.  These are economic fact.  Inflation is not.

A currency is a security issued by a government or banking institution, in the case of the US dollar the US Federal Reserve.  Don’t take my word for it … just take one out of your wallet and read the inscription: Federal Reserve Note.  What if we used a different security, maybe one issued by an industrial corporation, say General Motors?  

Let’s try its common stock as the security we use to price things in.  The first thing we might notice is that the price of General Motors stock doesn’t change.  The price of a share of GM stock is always one share of GM stock.  Instead we see that when GM’s business is weak we have rising prices and call it “inflation”; and conversely if GM is selling a lot of cars we observe falling prices and assert there is “deflation”.  

Likewise the price of one US dollar is always one US dollar, and we only observe changes in its value by noticing the prices of other things change.

Next let’s try as our unit the basket of shares known as the S&P 500.  One of the first things we would notice is that the 1980s and 1990s were characterized by strong deflation.  Most years your unit bought you more than the year before and prices fell relentlessly.  Pointedly, through this powerful deflation most people would characterize the economy of those decades as strong and prosperous … laying waste to the common assumption that deflation is “bad for the economy”.

What if we instead used gold?  The same two decades saw rampant inflation as your money unit lost over 80% of its purchasing power.  

But using gold as our pricing unit the notoriously inflationary 1970’s weren’t so inflationary after all … that instead a powerful wave of deflation had enveloped the US economy and prices fell as money gained purchasing power.  Using dollars as our unit of account prices rose, but by simply choosing ounces of gold instead we find sharply decreasing prices.  If inflation were a genuine economic condition how could it be so subject to an arbitrary choice made by the statistician?  Even if we stipulate that our choice of currency will be the official legal tender, are we prepared to assert that a fundamental economic condition is subject to mere political fiat?  

If that could be the case, then why not just have Congress decree poverty obsolete and pass a prosperity resolution every year?  

It should be clear by now that if you hear people trying to tell you that technology or globalization is deflationary or employment or tariffs is inflationary you should be skeptical, very skeptical.  Those are real phenomena. Inflation is a monetary phenomenon.  It is not a macroeconomic state or process.  

Inflation is a process of depreciation of a unit of account … and exists only in reference to that unit.